Paying Off Your Mortgage vs Investing

mortgage rates have surged and stayed high in the UK for those with mortgages they're probably thinking well should I bother with investment at all maybe I should just pay off my mortgage so in this video we're looking at how to structure that decision but also the factors that you should consider when making it this video is sponsored by trading 212 which is a UK commission free trading platform so let's look at whether it's better to pay off your mortgage or invest in a bit more detail let's begin by looking at what's changed the last time I made a video about this was in 2021 and it's really as if we're looking at two different worlds interest rates then were around two percent and now we're looking at Double that so a mortgage rate of five percent or more Is Not Unusual so if we look at UK two-year fixed mortgages and this is if you're borrowing 75 percent of the value of the house or 75 LTV loan to value as it's called you'll be paying a rate of around 5.7 percent just under that right now and if you've got a five-year fix there's going to be around 5.2 percent so what does that mean in terms of interest payments per month well if we look at an average mortgage of say 300 000 pounds what we're looking at is an increase of about 40 percent in monthly payments from around 1300 per month all the way up to about 1900 per month now one really important factor in determining your interest rate that you pay for your mortgage is that loan to value amount so the more you borrow the bigger the risk to the bank and the greater the rate that they'll charge you such that for a two-year fix rate if you have a loan to value of sixty percent you'll only pay around four and a half percent whereas if you have a loan to value of 95 you'll pay 5.8 percent much higher so the question we'll try to address in this video which seems on the face of it very simple but of course isn't is whether you should if you've got a lump sum or disposable income use it to pay off your mortgage or to to put it into say the stock market Now Stocks typically return nine percent per year historically that's been the case now that might seem pretty high to you and we'll look at the evidence for that but certainly now that interest rates are much higher at 5.7 percent there's not such a big difference between the two so paying off the mortgage is now looking more attractive as a choice so I said nine percent return for stocks that seems pretty Punchy what's the evidence for that now the evidence I'm going to use here is something I often quote which is the global returns yearbook which was from Credit Suisse now it's going to be from UBS I guess and that shows you the returns for stocks but also for property over 120 year period now UK stocks have returned on average around 5.3 percent between 1900 and 2022 whereas UK houses have returned around 1.8 percent over that period now these are real returns we've subtracted their rate of inflation and so the returns are actually higher than that in nominal terms if you ignore inflation notice also that the period for stocks is slightly longer than it is for the housing market that's because there wasn't an update since 2018 in the versions of the report which I've got but this is 120-year period so whether we add five years or not isn't going to make a huge difference the situation is even more extreme in the US where stocks have returned 6.4 since 1900 and houses have just beaten inflation by 0.3 percent now if we ignore inflation and here I don't have housing market data phenomenal returns as they're called that's where you get these values of nine percent so if UK stocks is high for one percent for U.S stocks is 9.5 over that period now Vanguard produces a 10-year Outlook which looks at those long-term returns called those the base rates and it also modifies them based on things like how expensive stocks are and the US is now looking quite expensive again and so that tends to reduce the decade ahead returns so for the most expensive U.S stocks those are growth stocks there's a very poor forecast so growth stocks in the US are only expected to return in nominal terms not considering inflation 2.4 percent over the next decade U.S equities as a whole also not so great 5.1 percent if we strip out the us from our Global stock returns we're going to get around 7.4 percent and if we just focus on developed markets then you'll get around 7.1 according to this forecast but still these rates are higher than what you'd get for the housing market which is usually much lower than that now for the UK we've got a huge amount of information about its policy rate which goes all the way back to 1694. now typically that's around five percent and the recent decade which we've had of ultra low interest rates are in fact very unusual even if we focus on the recent period the typical rate's been around five percent now that's well below the 9.1 percent that you get for stocks in the UK now the rate that you pay on your mortgage is usually a little bit more than the bank rate because they have to factor in things like credit risk or a lot more if you have a very high loan to value so what you can see is that it's been very unusual for the bank rate to exceed what you get for equities so even if interest rates in the UK were six percent they'd still be a little bit less than you'd expect to earn on stocks even Global stocks now I'd like to thank trading 212 which is sponsoring this video and it's a platform I've been using for some time now in the UK and I like it for a number of reasons the first one is that it's very low fee it doesn't charge a commission and that makes it very competitive also it's very Innovative so for example let's say you wanted to regularly say save money into your account and you wanted to put it into the same mix of assets those could be stocks they could be funds how could you do that would he create something called a pie this is almost like a fig set of Weights a portfolio within a portfolio and that way you can always save to the same Assets in the same proportions another problem that you often face as an investor is that some assets get ahead of the others they have a higher return and that actually it changes the risk profile of your portfolio how can you get around that will you have to rebalance you sell the thing which is increased in value and you buy the thing which is fallen in value that can be quite tricky to do to get back to the original percentage weights but with the pi feature you just click one button it makes it very easy to rebalance another really powerful feature of Pies is that they have a social aspect so you can look at other people's pies which they've published or you can publish your our own pies and that way you can be inspired to create your own portfolio based on other people's research or you can share your research and your portfolios for example I've created a set of portfolios called the asset mix portfolios which you can find on the platform now as a view of pension craft you get a special offer from Trading 212 where you can claim a stock worth up to 100 pounds so to get that you have to open a new account with trading 212 you have to verify it you have to deposit at least a pound and you also have to use my promo code which is my first name r-a-m-i-n so now let's consider the pros and cons of paying off your mortgage now it's not just about calculating returns and comparing different economic outcomes psychology plays a large part in this decision some people simply prefer to own the bricks and mortar that they live in than say investing in the stock market which is very uncertain so for those people sure paying off your mortgage should come first however other people simply say I'll just do whatever's gonna give me the best possible outcome economically so for those people they should favor investing because usually that's going to give you a higher return now it is less uncertain if you pay off some of your mortgage because what that guarantees is that you're going to get a positive economic benefit over the period during which the mortgage is fixed rate now for the UK that's usually two years sometimes it's five years we do get some longer term mortgages but they're quite unusual after the fixed period ends you're back into the realm of uncertainty because you don't know what the interest rates are going to be at that point so it does become less uncertain if you pay off your mortgage it is always a positive benefit sometimes stocks have negative returns but what you don't know is what happens beyond the fixed Point sometimes rates will be lower and in that case maybe you don't want to pay off so much of your mortgage but certainly During the period of the fix you're going to get a known outcome your disposable income will increase and you'll get that extra comfort of knowing that you own more of your house one of the drawbacks with paying off your mortgage is that once you put money into the mortgage it's difficult to get it back out so that means it's reducing the liquidity of your overall wealth and that reduces your options so to take an extreme example let's say you panic about high interest rates you take all your available savings and you plow them into your mortgage well now if you lose your job say you're going to be left with very little spare capacity and you could even lose your house so one other option is you have something called an offset mortgage where your actual deposit with a bank offsets the amount you've borrowed from the bank and reduces your monthly payments what that offers you is the flexibility to take money out of that savings account so you can still borrow more against your house effectively the drawback with that is usually you'll pay a higher rate than you would if you just had a normal mortgage so you might be better off having a lower loan to value by paying off more Capital than you would in having that flexibility so again here there's a trade-off now let's consider the pros and cons of investing now if you've got a mortgage the most that you can ever benefit from paying it off is the total amount of Interest you'll pay over the lifetime of the mortgage and that's finite if you contrast that with stocks there is no upside limit essentially you have unlimited upside another benefit with Investments like stocks or stock funds or bond funds or money market funds is that they're very liquid you can sell them almost immediately and that means that you've got more flexibility so let's go back to that scenario where you decide to invest all of your spare Capital but instead of paying off your mortgage here what you're going to do is invest it the difference is that if you lose your job you could almost immediately sell those Investments and live off the proceeds so it does give you that liquidity that flexibility when it comes to your choices later on another benefit of investment is that you can diversify them so you can split your money across different countries across different asset types and across different sectors if you invest all of your money into property you're concentrated in a single country in a single asset class and in a single currency if something goes wrong economically for that country then your house could lose value and you could end up with an underperforming investment or even negative equity another problem is that Investments are uncertain we said earlier that during the fixed rate period of the mortgage you know exactly what benefit you'll get from paying off x amount of pounds or dollars for the stock market it's not that simple so for example if you look at stocks in the US the S P 500 and we look at real total returns so dividends we invested inflation subtracted and we look at increasing intervals of time what's really interesting is if a short periods of time yes stocks are very uncertain so the shortest interval you can see on this graph is three years notice that the returns vary hugely over this 150-year period if we look at every three year period within it sometimes the returns are higher than 20 percent sometimes they're lower than minus 10 percent but notice that as we gradually increase the interval over which we're investing what happens is the uncertainty diminishes such that if we invest for 15 years or more the returns are never negative and they convert urge on the long-term average return which is around seven percent for the US so really when we're talking about uncertainty we also have to consider the investment Horizon and for a 25-year period which is what we're talking about with mortgages stocks actually are quite predictable at least they have been historically but if you are the kind of person that's nervous about investing in stocks well it doesn't have to be stocks at the moment one of the benefits of the bank of England for example raising interest rates is that you can earn more interest as a saver so if we look at the Sterling overnight index average rate which is a bank lending rate you can earn that very easily and safely with a money market fund and currently that's around 4.4 percent that's less than you'll have to pay on your mortgage but it does offset some of that cost or you could create a portfolio of dividend paying stocks to generate a steady income so even if you did lose your job say you'd still have have that source of income to tide you over until you did find something else because remember what the bank of England and other central banks are trying to do right now is to get us to borrow less spend less and save more so don't fight the FED don't fight the bank of England do what they kind of want you to do and make use of that higher interest rate as a saver also this lets you keep your cash in easily accessible form in a liquid form which might be better down the road so how do we figure out the break-even point for rates to work out when it's better to pay off your mortgage or to invest well roughly the break-even point occurs when the rate of investment net of tax is equal to the rate you're paying for your mortgage or your loan if the rate of return on your investment is higher then you're better off investing if it's lower you're better off paying off your mortgage it's actually a little bit more complicated than that and that's because the numbers you get out of the calculation and non-linear they don't scale up and down exactly in line with the percentages you pay so let's take a look at this example with a 30 year old who's got a 35k salary a 300K mortgage let's say that they've paid a 10 deposit they've also got a mortgage rate of around five percent which is close to where we are now now for members of pension craft we've got this spreadsheet which allows you to work out what the benefits are of paying off your mortgage or investing and you can vary any of the numbers in this spreadsheet and that's what we'll be using to do this calculation so to get us started let's take a really extreme example where we receive a huge win for the day after we take out our mortgage and we'll pretend that we're not going to have a prepayment penalty or any other complication here so we get 270k and we can either pay off our mortgage or invest that say in the stock market now over the course of the 25 year mortgage you'll pay a huge amount out of Interest you're going to pay 204 000 pounds so that's roughly equal to the amount that you borrowed in the first place so by paying off your mortgage immediately you're saving that 204 000 however if you took that 270 000 and invested it into the stock market and let's say the returns are low-ish compared to history so six percent well that's going to turn into 1.2 million over that 25 year period And if the rate of return on investments was closer to that nine percent then we're talking about twice as much for your investment over 2 million so you can see what a huge difference that fairly small difference in percentages can make compounded over 25 years now nobody knows what the return on your investments will be over the next 25 years we know roughly but not exactly but we also don't know what the interest rate on average will be over that 25 year on a mortgage you might have a two-year five-year fix but it's not fixed for the life of the mortgage so what you can do with this grid which I've displayed is work out what you think is going to be the rate of return on investments and on your mortgage and then see which is going to be better for you the green bits are where the mortgage rate is greater than the investment rate and there you're better off paying off your mortgage the red bits are where the rate of return on your Investments is greater than the mortgage rate so there you'd be better off investing in fact it actually gets shifted slightly in favor of the Investments so to break even you actually have to have mortgage rates a little bit higher than the rate of return on your Investments and that's because of the capped upside the benefit is capped with your paying off the mortgage as we saw in the really extreme example earlier you can only save the total amount of Interest over a 25-year period and you can't benefit beyond that when you're paying off your mortgage but there's another way of looking at this which is an incremental terms so let's look at the benefit to this person of overpaying their mortgage with one percent of their 35k salary or investing that one percent of their salary in the stock market say now for every one percent of their annual income which they invest in their mortgage by overpaying their mortgage they'll save 11k 11 000 pounds over the life of the mortgage for every one percent of their income which they invest in the stock market however if they assume a rate of six percent on those Investments they're going to make roughly 15K over the lifetime of the mortgage if returns are nine percent on the stock market in line with long-term averages then you'd make 29k for every one percent you put into your investments in conclusion then I think the first point is that there is no simple answer it seems like a simple question but you can see the complications it's not just about money it's also about psychology and what your preference is for risk but also the pleasure of owning your own house now it is the case that economically you're usually better off investing than pay off your mortgage so I think all I'd say is Don't Panic about very high interest rates and jump into overpaying your mortgage and then ending up in that inflexible situation where you haven't got much Capital left at least with Investments you've always got the choice of doing that further on down the road and that's because of the liquidity of the Investments themselves so it's only one of the factors you should be considering is how important certainty is to you would you rather the certainty of having a greater disposable income slightly greater when you have the fixed period for your mortgage if you overpay or would you rather have the greater economic gain over the long term or to put it another way is certainty more important than return but I think the key Point here is that most people will choose to do both things at once it's not a binary choice you could choose to pay off your mortgage and to invest in the stock market Bond markets and now money market funds which are looking more attractive so there is no right or wrong answer here either way you're going to be doing something which is in your benefit either because it increases your disposable income and reduces your debt or because it increases your long-term wealth because you've invested into the stock market say but I think I wouldn't really panic and rush into a decision it's really more about discussing this with your family members who this affects but also considering your own psychology and about what you think is important in life now don't forget our offer from Trading 212 if you want to make use of that you can get a stock worth up to 100 pounds if you use my name as a promo code Ramin and also you have to open up a new account and verify it in order to get access to it and and as always thank you for listening

Channel: PensionCraft

Views: 92,627

Keywords: invest, invest or pay off debt, investing, money, mortgage, overpay mortgage, pay off mortgage or invest, pay off your house or invest, pay off your mortgage early, paying off your mortgage vs investing, pension craft, pensioncraft, ramin nakisa, should i pay off my mortgage early, should you pay off your mortgage or invest, stock market

Id: alYJANG__To

Length: 21min 3sec (1263 seconds)

Published: Sat Jun 10 2023